Use of Non-GAAP Financial Measures
Public companies often use non-GAAP financial measures to help investors and other users of the financial statements understand a company’s performance and/or financial position in different ways than US GAAP metrics show. While the use of these non-GAAP financial measures is allowed, registrants are often placing too much prominence and emphasis on them to the detriment of their primary US GAAP financial measures.
On May 17, 2016, the SEC updated their interpretive guidance on non-GAAP financial measures in order to provide clarity on misleading non-GAAP presentations and non-GAAP measures. The SEC has long had concerns regarding these non-GAAP measures. However, the measures were not regulated until the Sarbanes-Oxley Act of 2002 (SOX) was passed, which allowed the SEC to implement and enforce rules relating to non-GAAP financial measures.
According to SEC Chair Mary Jo White, “the non-GAAP information, which is meant to supplement the GAAP information, has become the key message to investors, crowding out and effectively supplanting the GAAP presentation.” The SEC believes that these non-GAAP financial measures can be potentially misleading, can change the effectiveness of GAAP measures, and may not be comparable amongst companies or between different periods. Additionally, these non-GAAP financial measures are making companies’ earnings look stronger than they actually are, creating questions from the SEC. Mark Kronforst, Chief Accountant of the SEC’s Corporate Finance Division, believes that companies will soon see “an uptick” in the number of SEC comments on these non-GAAP financial measures.
Many companies are now reporting both non-GAAP and GAAP financial measures in their financial statements, which has many users of the financial statements leery. Non-GAAP financial measures include stripping out noncash and nonrecurring items from a company’s financial results as certain companies believe that excluding these financial measures portrays a better view of a company’s true earnings and performance. One common non-GAAP financial measure that is used is earnings before interest, taxes, depreciation and amortization (EBITDA). By using EBITDA, companies believe they are showing a clearer reflection of operations by stripping out certain expenses. A second common non-GAAP financial measure is funds from operations (FFO), a measure commonly used by real estate investment trusts. FFO is used by companies to define its cash flow from operations.
According to the SEC, there are certain requirements and certain prohibitions that non-GAAP financial measures must adhere to. One requirement for non-GAAP financial measures is presentation and reconciliation. The SEC rules state that non-GAAP financial measures must be accompanied by, and reconciled to, the corresponding GAAP measures in a manner that is consistent with their use as either performance measures or liquidity measures, and those GAAP measures must be presented with equal or greater prominence. While there are different ways that SEC registrants present non-GAAP financial measures such as using a bolding font or a larger font, the GAAP counterpart must still be displayed more prominently. Other examples that would cause an overemphasis on non-GAAP financial measures are omitting comparable GAAP measures from headlines or captions and presenting a non-GAAP measure that precedes the GAAP counterpart, amongst many others. The second requirement is that there must be a disclosure relating to the non-GAAP financial measure explaining why the non-GAAP financial measure is useful to investors and how management uses the measure internally.
Certain constraints over the presentation of non-GAAP financial measures include that the disclosures must not be misleading and there are certain prohibitions. The disclosures cannot contain an untrue statement of a material fact or omit a material fact in which inclusion will make the presentation of the non-GAAP financial measure not misleading. Companies are also not allowed to present non-GAAP financial measures on the face of the financial statements. These constraints help to ensure that GAAP measures are always presented more prominently to investors.
To summarize, GAAP financial measures and related disclosures are still king and the SEC is implementing certain steps to ensure that this does not change. Non-GAAP financial measures can undoubtedly be useful in many scenarios. However, it has now come to a point where these measures can be misleading and cause investors and analysts to overemphasize these measures, instead of their GAAP counterparts.